Wednesday, January 23, 2013

The technique of momentum trading

Momentum trading, the focus of the technical discipline utilized by the Momentum Strategies Report, is based on three major pillars:

1.    Market trend/momentum
2.    Internal trend/momentum
3.    Fundamental trend/momentum

Momentum trading is based on the axiom that a “trend in motion tends to stay in motion unless acted upon by an equal and opposite force.”  When the broad stock market is in a bullish trend as defined by expanding new 52-week highs and shrinking 52-week lows on a rate of change basis, the best individual stock trades tend to be those with little or no overhead resistance.  In other words, stocks with strong chart patterns in clear rising trends. 

One of the best ways of identifying top-flight momentum stocks is by starting with the 3-month or 6-month daily chart, then expanding the time frame to at least a 4-year monthly chart.  Ideally, of course, the stock in question should have strong earnings and revenue growth with bullish analyst expectations for the next 3-4 quarters.  Once the company’s fundamental strength has been ascertained, it’s time to focus on the stock’s technical strength.

Technical strength is best measured by taking a relative strength survey of the stock in relation to both the broad market S&P 500 Index as well as the industry group it trades in.  You’ll do well to ask yourself, “Is the stock showing relative strength on a short-term as well as an intermediate-term basis?”  If the answer is yes, then proceed to the next step of evaluating the structure of the charts.

Let’s take one of our more recent stock picks, namely PulteGroup (PHM).  When we first evaluated this stock a few weeks ago in the newsletter it was clearly that the 3-month daily chart had a bullish structure.  You can still clearly see this in the following chart example. 

Even more importantly, PHM had/has a bullish 4-yearly month chart structure with no overhead resistance/supply in sight (see below).

An even longer-term graph depicts chart resistance beginning around the $24-$25 area.  But for short-term trading purposes a 4-year monthly chart will typically suffice for giving you a good idea how much upside potential and forward momentum a stock will enjoy in a confirmed bull market. 

Now compare this to another stock in the home building industry, namely D.R. Horton (DHI).  Unlike PulteGroup, DHI has more near-term overhead chart resistance to contend with.  You can see this resistance around the 22.00 level beginning around late October/early November in the 6-month chart shown here.  This resistance is even more visible from the vantage point of the 4-year monthly chart (not shown).  Not surprisingly, DHI has lagged the home construction industry group for this rally and hasn’t yet made a new 52-week high, unlike PHM.

The lesson here is that it usually pays to do relative strength and momentum studies when selecting stocks for trading and investing.

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